chapter 14: capital structure and dividend policy outline: capital structure of a company use of...
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Chapter 14: Capital Structure and Dividend Policy
Outline: Capital Structure of a Company Use of Private Equity Dividend Policy Dividend Considerations Repatriation of Capital for
Multinational Companies (MNCS)
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 10: Module 5, Chapter 14 - 1
Capital Structure of a Company
Optimal and target capital structures Trade-offs between financing with
long-term debt and common stock Capital structure theory
Trade-off theory Business and financial risk
Operating risk and operating leverage Financial risk and financial leverage
Target capital structurev3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 10: Module 5, Chapter 14 - 2
Discussion Question
What are the advantages and disadvantages of debt financing?Answers:
Advantages Costs less than
equity Fixed or floating
rates Capital markets for
long-term debt are efficient
Earnings are not diluted
Owners of the company’s debt do not vote
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 10: Module 5, Chapter 14 - 3
Disadvantages Has priority of claim over equity Inability to service debt will cause
bankruptcy Increases company
risk and can increase WACC
Usually accompanied by liens on assets
Places monitoring requirements on the company
Advantages and Disadvantages of Common Stock Financing
Advantages No obligation to
make fixed payments to investors.
Does not mature. Cushion against
losses for creditors. If company has
bright future, equity can be raised on attractive terms.
Disadvantages May dilute voting
rights, control and value.
Cost of underwriting is significant.
Unlike debt, common equity financing has no tax shield.
May erode the stock price.
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 10: Module 5, Chapter 14 - 4
Capital Structure Theory: Trade-Off Theory Companies trade off the use of debt and
equity in their capital structures. As debt is substituted for equity, the
overall cost of capital (WACC): At first decreases as debt is increased. Then rises as more debt is added.
The mix of debt and equity associated with the lowest WACC is the optimal capital structure.
Real-world factors.
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 10: Module 5, Chapter 14 - 5
Discussion Question
What is the difference between operating leverage and financial leverage?
Answer:Operating leverage is the result of fixed costs in operations; it magnifies the impact of changes in sales on EBIT.
Financial leverage results from fixed financing costs (interest); it magnifies the results of changes in EBIT on net income.
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 10: Module 5, Chapter 14 - 6
Degree of Operating Leverage (DOL) DOL shows the responsiveness of operating profit to
changes in sales. Example: sales increase 20% but operating profit
increases 33% because fixed costs are stable at $2,000.
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 10: Module 5, Chapter 14 - 7
% Change in EBITDegree of Operating Leverage =
% Change in Sales
33%= = 1.65
20% The percentage change in EBIT is 1.65 times as much
as the percentage change in sales; proportionately EBIT is 1.65 times as volatile as sales. If sales decline, EBIT declines proportionately faster.
Degree of Financial Leverage (DFL)
More debt in capital structure = higher interest. Larger fixed interest expense causes net income to be
more volatile in response to changes in operating income.
Example: 33% increase in EBIT results in a 50% increase in net income.
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 10: Module 5, Chapter 14 - 8
Net income will increase proportionately 1.515 times as fast as EBIT. If EBIT declines, net income will decline proportionately faster.
% Change in Net IncomeDegree of Financial Leverage =
% Change in EBIT
50% = = 1.515
33%
Other Considerations in the Capital Structure Decision Rating agency and lender
considerations Limit actions to comply with covenants. Ratings triggers require scrutiny.
Issue of control Too much equity risks takeover, too much
debt risks bankruptcy. Regulatory restrictions and minimum
capital requirements
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 10: Module 5, Chapter 14 - 9
Discussion QuestionWhich of the following is often used in the final stages of a leveraged buyout or venture capital investment in order to raise the full amount of capital needed for purchasing a company using private equity?a) Leveraged buyoutsb) Venture capitalc) Growth capitald) Distressed investmentse) Mezzanine capital
Answer: e
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 10: Module 5, Chapter 14 - 10
Advantages and Disadvantages of Private Equity
Advantages Simplicity Better alignment of
ownership and management
Capital structure Tax advantages Reduced reporting
requirements
Disadvantages Increased debt load
in LBOs Loss of control for
existing owners Required exit
strategy
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 10: Module 5, Chapter 14 - 11
Constraints on Dividend Policy
Bond indentures and loan covenants
Prevent stockholders from draining assets.
Preferred stock Cumulative dividends in
arrears must be paid in full before any common dividend can be paid.
Impairment of capital Dividend payments usually
cannot exceed retained earnings on the balance sheet.
Cash adequacy Sufficient cash to pay
dividends?
Tax on excess accumulated earnings
IRS special surtax on improperly accumulated income (avoiding personal taxes).
Control of privately held companies
Maximize retained earnings, minimize dividends.
Investment opportunities Limit the size of dividends to
increase available capital. Availability of alternative
capital sources Ability to raise new equity may
increase likelihood of dividend payouts.
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 10: Module 5, Chapter 14 - 12
Information Content of Dividends Valid evidence that
dividends have a “signaling” effect.
Given stable dividends or constant growth rate: Deviation impacts share
price Increase bids up,
decrease bids down Choice of dividend
policy between profit distribution/capital gains yield does not influence stock price.
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 10: Module 5, Chapter 14 - 13
Dividend Payment Procedures
Date DefinitionDeclaration date Date board announces (declares)
dividend
Record date Date specified by board when holders-of-record are entitled to receive declared dividend
Ex-dividend date Date stock is sold without dividend entitlement (two days prior to holder-of-record date)
Payment date Date dividend is paid
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 10: Module 5, Chapter 14 - 14
Dividend Reinvestment Plans (DRIPs) Allow investors to
increase ownership of shares in the company.
Existing shareholders purchase shares:
Directly from the company
On a when-desired basis
Normally with no commission
Automatic reinvestment of dividends in additional shares allowed.
Shares distributed under DRIPs may be: Held in the treasury Repurchased by the
company in the market
New, authorized shares of stock that have not been issued yet (shelf registered)
Benefits smaller shareholders.
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 10: Module 5, Chapter 14 - 15
Different Types of Dividends
Cash dividends
Stock dividends
Special dividends
Liquidating dividends
Stock splits
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 10: Module 5, Chapter 14 - 16
Stock Repurchases
Advantages Reduces number of
shares outstanding Increases earnings per
share Increases market price
per share if market hasn’t reevaluated firm’s prospects
Investor can “create” dividend by selling shares
Disadvantages Regular repurchases
may be viewed by investors as attempt to: Increase stock price in
absence of better alternatives
Counteract earnings dilution from executives exercising stock options
Inadvisable unless P/E ratio is believed lower than justified
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 10: Module 5, Chapter 14 - 17
Repatriation of Capital by Multinational Companies (MNCs) Foreign subsidiary pays dividends to parent
company. Governments often act to restrict
repatriation of capital, including dividend payments.
MNCs unbundle cash flows from subsidiaries; easier to justify to foreign governments than dividends: Management fees Transfer pricing Intracompany loans
v3.0 © 2011 Association for Financial Professionals. All rights reserved. Session 10: Module 5, Chapter 14 - 18